Launch of the Czech Republic Economic Survey

It is a pleasure for me to be here to introduce the 2010 OECD Economic Survey of the Czech Republic.

The economic challenges facing your country in these first stages of the recovery will present the government with difficult choices, but also with important opportunities. The key challenge will be to navigate a course that helps to strengthen the nascent recovery, while laying the foundations for strong performance over the long term.

1. The Czech economy has weathered the crisis well

The Czech economy faced the crisis with strong macroeconomic fundamentals. With reasonable external and fiscal balances, a flexible exchange rate – linked to solid fundamentals, low inflation, sound banks and an absence of domestic financial bubbles, the country did not look particularly vulnerable to the international financial turbulence.

However, as one of the most open economies in the OECD, it was severely affected by the global trade collapse at the end of 2008. This triggered a contraction in domestic demand, and the Czech recession, though short, turned out to be almost as sharp as in Germany, its major trading partner, likewise seen as a strong, solid economy. Like the downturn itself, the resumption of growth was driven largely by developments in external markets, which remain critical to growth prospects.

Thanks to the country’s pre-crisis record, Czech households and firms have entered the recovery without the kind of debt burdens that remain a drag on growth in many other economies. The fact that the banking sector appears to have come through the downturn in reasonably good shape is to be commended. Thus, the authorities do not face the challenge of unwinding the kind of costly emergency interventions in the banking sector seen elsewhere. Moreover, there are not many countries with high investment needs where domestic lending is financed through domestic savings. The loan to deposit ratio remains well below 100%. In the aftermath of a global credit-crunch, this is an important comparative advantage.

However, the downturn exposed one principal weakness that needs to be addressed. The deterioration of public finances during the course of last year was far greater than anticipated. In hindsight, fiscal policy prior to the crisis was rather pro-cyclical. Even at the top of the cycle, in 2007, the general government balance was in the red. When the crisis hit, there was limited room to allow the automatic stabilisers to work, let alone to undertake a significant discretionary fiscal stimulus.

As you know, the government’s response shifted relatively quickly from stimulus to consolidation; a move that is to be welcomed. Rapidly rising deficits put pressure on the government’s cost of borrowing – which would have offset much of the impact of further fiscal stimulus. Moreover, the effectiveness of fiscal stimulus in such an open economy was somewhat doubtful.

To be able to cope with potential future external shocks, the Czech economy needs room for fiscal manoeuvre. Therefore, an important goal for the medium-term should be to bring the structural balance close to zero. Such a target would also generate downward pressure on the debt to GDP ratio. This, in turn, would help to face the challenge of population ageing.

2. Strengthening public finances

The experience of the Czech Republic and other OECD members, has underlined the case for a more rigorous, rules-based approach to fiscal policy. To avoid overspending in good times, a structural budget–balance close to zero should complement the current nominal expenditure ceilings. The experience of OECD member countries with constitutionally entrenched fiscal rules, and/or independent institutions for monitoring fiscal policy, point to additional reform options, which could be explored.

The current government has made an important start. However, like previous consolidation efforts, the current measures are heavily tilted towards the revenue side. The experience of other OECD countries shows that fiscal consolidation is much more likely to be sustained if it is based on structural reductions in public expenditure. Consolidation efforts based on expenditure restraint are also consistently associated with better growth performance. Consolidation plans for 2011 and beyond should therefore give greater weight to controlling expenditure.

Some additional revenue measures are, nevertheless, likely to be required in the years ahead. Therefore, it is important to identify the revenue sources that are least distorting and least damaging to growth. This means that the focus should shift to indirect taxes, particularly consumption, real estate or environmental taxes, rather than labour taxes or capital income.

To be successful, consolidation needs to be underpinned by structural reforms. Those will require time to prepare and discuss. Meanwhile, there are areas where the government can act immediately. Reforms to the budgetary process, in particular, could pay significant dividends in coming years. Such reforms could include rigorous ex-ante and ex-post scrutiny of expenditure programmes, improvements in budgetary transparency, speedy implementation of plans for a treasury system and an overhaul of public procurement practices.

Focus on taxes and benefits

Social expenditure represents the largest share of non-discretionary public spending, so action in this area is likely to be required as part of any consolidation effort. Czech policy makers need to review social spending, with particular attention to identifying non income-tested benefits that could be phased out at higher incomes. Tax-benefit interactions should also be addressed in order to support the recovery and provide incentives to people to return to work. The analysis in the Survey suggests that the Czech Republic has made considerable progress in addressing inactivity traps since 2006. However, some workers still face tax-benefit combinations that discourage them from taking up jobs or increasing working hours.

This is particularly true in the area of family benefits. Parental allowances and other benefits available to families with young children are still heavily oriented towards de-activating parents for relatively long periods. This contributes to both poorer long-term productivity performance and larger gender pay gaps. The government should make it easier to combine work and family life by adjusting the system so that it is neutral with respect to parents’ choices.

Addressing the fiscal consequences of an ageing population and health system reforms

Rapid population ageing will put the Czech public finances under pressure over the long term. Healthcare and pensions will account for the largest part of the growth of age-related public sector expenditures, which are projected to rise by 6 percentage points of GDP over the period to 2060. Reforms in these two areas have been initiated but they have largely stalled in recent years and need to be reinvigorated. Ensuring the long-term health of the pension system is likely to require a combination of further parametric adjustments and structural changes aimed at diversifying the sources of retirement income. A first step would be to phase out the differentiation of women’s retirement ages depending on the number of children they bear. The government should also consider partial indexation of the retirement age to life expectancy.

In healthcare, plans to improve the definition of the basic healthcare package provided by the public system and increases in diversity of insurance products should go ahead. They are essential preconditions to any serious attempt to deal with future rising costs.

3. Improving the business environment through regulatory reform policies

Reducing the regulatory burden on business offers a good way for the government to reduce pressure on the enterprise sector and help the nascent recovery at little or no fiscal cost. Despite important recent reforms, much remains to be done to lower entry barriers in product markets, strengthen competition, particularly in network sectors, and relax labour market regulation.

The Survey contains a number of specific proposals on these issues. In network industries the evidence points to the need for continued vigilance against possible exploitation of market power by dominant players. This matters because your tradable sectors rely on them for services and other inputs. Also, corruption – particularly in public procurement – has been highlighted as a major problem by Czech firms. Here the government should enhance transparency and competitiveness of public tendering.

Efforts to relax labour and product market regulation should also be underpinned by greater consistency in the implementation of regulatory policies. The drive to reduce administrative burdens and the introduction of regulatory impact analysis (RIA) are welcome. However, their implementation has been uneven and there is a need for new, more effective mechanisms to drive regulatory reform across the whole of the public administration.

Given the export orientation of Czech manufacturing, much of the business community is pressing for euro adoption. In view of the current fiscal situation, adoption of the euro can only be a medium term prospect. The timing of entry will depend on economic and fiscal developments that are hard to predict at this point. However, a clear strategy for eventual entry should help prepare the economy for life in the euro area. It could provide both an anchor for business expectations and some clarity about medium-term policy priorities. Meeting the Maastricht criteria is not enough. Structural and regulatory reforms need to facilitate swift response to external shocks without relying on exchange-rate adjustments.

Ladies and gentlemen,

The Czech Republic has a lot to gain from staying the course of reforms. I hope our Survey provides useful recommendations to support policy debates and action.

In closing, I would like to underline our overall assessment. The economy has shown considerable resilience in the face of extraordinary challenges. The authorities now need to support the recovery, while laying the foundations for strong performance over the long term. This means strengthening public finances and making the business environment more growth-friendly. Doing so will be easier if there is a climate of readiness to reform, to which we want to contribute.

We wish you every success in building on these achievements and consolidating the current recovery in the years to come. The OECD stands ready to support your efforts.